Battle lines are drawn; OCC debates charters for FinTech firms

The Office of the Comptroller of the Currency recently announced that it could consider applications from financial technology companies that want to become special purpose national banks.

While there are many benefits to tempt FinTech firms, there will be challenges and regulatory burdens that need to be carefully considered.

“The OCC made clear that in important areas—for example, anti-money laundering—that with a national charter you are going to need to meet supervisory expectations with respect to a compliance program,” says Arthur Long, co-chair of law firm Gibson Dunn’s financial institutions practice group. “That is the quid pro quo for the benefits of federal regulation such as preemption of certain state laws. This is not going to be regulation lite.”

In announcing the plan, the OCC stressed that firms that seek a charter will be evaluated to ensure they have a reasonable chance of success, appropriate risk management, effective consumer protection, and strong capital and liquidity.

During the past year, the number of FinTech companies in the United States and United Kingdom has ballooned to more than 4,000, according to the OCC. In just five years, investment in this sector has grown from $1.8 billion to $24 billion worldwide.

FinTech companies vary widely in their business models and product offerings, according to an OCC white paper that detailed the proposal. Some provide loans to consumers and small businesses, some offer payment-related services, and others engage in digital currencies and distributed ledger technology. Financial planning and wealth management products and services are the forte of other firms.

“Many will choose to partner with existing banks or provide services to banks and other financial companies, but some will seek to become a bank,” Comptroller of the Currency Thomas Curry said during a December speech at Georgetown University, announcing a public comment period on the plan. “In those cases, it will be much better for the health of the federal banking system and everyone who relies on these institutions if these companies enter the system through a clearly marked front gate, rather than in some back door, where risks may not be as thoughtfully assessed and managed.”

The OCC has authority to grant charters for national banks and federal savings associations under the National Bank Act and Home Owners’ Loan Act. That authority includes granting charters for special-purpose national banks.

Special-purpose national bank charters have been in use for some time. The most common types of these charters include trust banks (national banks limited to the activities of a trust company) and credit card banks (national banks limited to a credit card business).

A special-purpose national bank may engage only in activities that are permissible for national banks. These firms are subject to the same laws, regulations, examination, reporting requirements, and ongoing supervision as other national banks. These laws include, for example, statutes and regulations on legal lending limits and limits on real estate holdings.

The OCC has identified baseline supervisory expectations for any entity seeking a national charter. They stress the importance of governance, capital, liquidity, compliance risk management, financial inclusion, and recovery and resolution planning.

A “well-developed business plan” will also be required as a key component of any charter proposal. It should cover a minimum of three years and provide enough detail to demonstrate that the proposed bank has a reasonable chance for success, will operate in a safe and sound manner, and will have adequate capital to support its risk profile.

Laws that apply to special-purpose banks include the Bank Secrecy Act, anti-money laundering laws, and economic sanctions administered by the U.S. Department of the Treasury’s Office of Foreign Assets Control. Also, special-purpose national banks are subject to the prohibitions on engaging in unfair or deceptive acts or practices under the Federal Trade Commission Act and Dodd-Frank Act.

The OCC expects the governance structure for any proposed special-purpose national bank to be commensurate with the risk and complexity of its proposed products, services, and activities, as it is for other national banks. The board of directors must have a prominent role in the overall governance structure by participating on key committees and guiding the risk management framework. Board members must also “actively oversee management, provide credible challenge, and exercise independent judgment.”

The OCC serves as the primary prudential regulator and supervisor of national banks. Depending on the structure of the bank and the activities it conducts, other regulators will have oversight roles as well, including the Federal Reserve and Consumer Financial Protection Bureau.

“The OCC made clear that in important areas—for example, anti-money laundering—that with a national charter you are going to need to meet supervisory expectations with respect to a compliance program. That is the quid pro quo for the benefits of federal regulation such as preemption of certain state laws. This is not going to be regulation lite.”

“An applicant seeking a special-purpose national bank charter, like any applicant for a national bank charter, is expected to demonstrate a culture of compliance that includes a top-down, enterprise-wide commitment to understanding and adhering to applicable laws and regulations and to operating consistently with OCC supervisory guidance,” the proposal says. “In addition, the applicant would need appropriate systems and programs to identify, assess, manage, and monitor the compliance process (policies and procedures, practices, training, internal controls, and audit), and a commitment to maintain adequate compliance resources.”

As with any national bank, the compliance risk management system appropriate for a specific bank should consider the nature of the company’s business, its size, and the diversity and complexity of the risks associated with its operations. The OCC would consider and address in its evaluation of a FinTech charter application whether and how innovative elements of a business model may affect the proposed bank’s compliance risk profile.

“Being under supervision and examination by a federal banking agency has its own set of issues,” says Richard Eckman, a partner with law firm Pepper Hamilton. “You are, particularly at the beginning, going to be subject to very tight oversight. Getting a charter is going to be problematic in the sense that you are going to need a three-year business plan that is going to be rigorously reviewed. If you want to make any deviations from it because some new innovation comes along and you want to do something different, you need to go back to the OCC to get permission.”

“If you have never been subject to a bank regulatory scheme before, than you need to understand it very clearly and carefully before you make that jump,” he adds.

The OCC is also going to “take a very close look at what your capital needs are and where your liquidity is coming from,” Eckman says. “You are going to need to come up with a stable source of funding, which could be expensive and difficult to get. It is not impossible, but it is not for the faint of heart.”

Despite the challenges that come with submitting to a rigorous process of regulation and supervision, there are also potential competitive advantages.

“There is an opportunity in the marketplace for FinTech companies to really set themselves apart, not only in dealing with the public but particularly in dealing with other partners, whether it is funding sources or, especially, bank partners, by getting this seal of approval from the OCC in the form of a bank charter,” says Jonathan Hightower, a partner with law firm Bryan Cave who advises banks and their boards on strategic plans. “It does mean a lot, especially for bank partners, to know that you have been through a rigorous regulatory review and if you stray off the path, that regulator is going to be there to address the issue.”

As he sees it, most FinTech companies will be buying the advantage of multistate preemption and forgoing what are potentially 50-state licensing projects in order to expand their business nationwide.

BIG QUESTIONS

The following questions were posed for public comment by the Office of the Comptroller of the Currency in its recent white paper regarding the granting of special purpose national bank charters for FinTech firms.

What are the public policy benefits of approving FinTech companies to operate under a national bank charter? What are the risks?

What elements should the OCC consider in establishing the capital and liquidity requirements for an uninsured special purpose national bank that limits the type of assets it holds?

What information should a special purpose national bank provide to the OCC to demonstrate its commitment to financial inclusion to individuals, businesses and communities?

What new or alternative means (products, services) might a special purpose national bank establish in furtherance of its support for financial inclusion?

How could an uninsured special purpose bank that uses innovative methods to develop or deliver financial products or services in a virtual or physical community demonstrate its commitment to financial inclusion?

Should the OCC seek a financial inclusion commitment from an uninsured special purpose national bank that would not engage in lending, and if so, how could such a bank demonstrate a commitment to financial inclusion?

How could a special purpose national bank that is not engaged in providing banking services to the public support financial inclusion?

Should the OCC use its chartering authority as an opportunity to address the gaps in protections afforded individuals versus small business borrowers, and if so, how?

What are potential challenges in executing or adapting a FinTech business model to meet regulatory expectations, and what specific conditions governing the activities of special purpose national banks should the OCC consider?

What actions should the OCC take to ensure special purpose national banks operate in a safe and sound manner and in the public interest?

Would a FinTech special purpose national bank have any competitive advantages over full- service banks the OCC should address?

Are there risks to full-service banks from FinTech companies that do not have bank charters?

Are there particular products or services offered by FinTech companies, such as digital currencies, that may require different approaches to supervision to mitigate risk for both the institution and the broader financial system?

How can the OCC enhance its coordination and communication with other regulators that have jurisdiction over a proposed special purpose national bank, its parent company, or its activities?

Certain risks may be increased in a special purpose national bank because of its concentration in a limited number of business activities. How can the OCC ensure that a special purpose national bank sufficiently mitigates these risks?

How capable of meeting all requirements that will be put upon them are FinTech firms?

There are two major categories of challenges. “The first is from a cultural and experience standpoint,” Hightower says. “The average technology company out there just does not have the mindset of asking for permission or giving a heads-up to a regulator every time they decide to do something new. For that reason, it is going to be important for firms that choose to go down this path to bring in experienced banking management or board members.”

Another set of challenges comes with wanting to have an ever-evolving and fluid business plan when you are subject to a great deal of supervision.

“It does create a tension, because many of these companies are used to having an idea, having really smart people execute on that idea, and then implementing it,” Hightower says. “Maybe one out of every two ideas really works out in the marketplace, but certainly not 100 percent or near it. In the banking space, however, you need to get it right nearly every time. It is not a space where we are allowed to tinker or experiment all that much. Safety and soundness is key, and well-thought-out, slow-growth business plans are appreciated by the regulators. That is a different mindset than the average technology company.”

While traditional banks may fret a competitive and regulatory imbalance, they too might also benefit from FinTech charters.

“It creates a real opportunity for the larger banks to have partners down the road through M&A,” Hightower says. “These FinTech firms will have done the hard work of creating an environment and a suite of products that work in a regulated and supervised environment. If I am an executive at a big bank, I am saying, ‘Bring it on, I’m your exit strategy.’ ”

The public comment period on the proposal, which closed on Jan. 15, gave voice to a range of concerns.

The PaydayFreeLandia coalition, representing 15 states, demanded today that the OCC “back off a dangerous plan that would gut their states’ strong consumer protection laws.”

The coalition represents states where predatory payday lending is legally prohibited. It signed onto a letter signed by more than 270 community, labor, and civil rights groups.

Among their concerns is the preemption of state-based regulations. “The OCC charter throws the door to the hen house wide open for the payday loan foxes that have long sought to dig their way into our states,” the letter says, adding that the charter plan would “effectively nullify critical existing state rate caps.”

The American Bankers Association expressed support of a limited purpose national bank charter for FinTech companies “as long as existing rules and oversight are applied consistent with those for any national bank.”

Rob Morgan, ABA’s vice president, urged the OCC to work with other agencies “carefully and cooperatively before any new charter is approved to assure that no current policy lines are directly or inadvertently moved as a consequence of this action.”

The proposal “lacks legal authority and threatens the growth of small businesses while potentially creating more ‘too big to fail’ companies with lax oversight,” says Maria Vullo, superintendent of New York’s Department of Financial Services.

“The OCC should not use technological advances as an excuse to attempt to usurp state laws that already regulate FinTech activities where they intersect with banking and lending, whether depository or non-depository,” she wrote. “A one-size-fits-all federal charter will not work to create a level-playing field among all financial services companies, or to alleviate risks. On the contrary, the proposal increases risk, creates an opportunity for regulatory arbitrage, and attacks states’ sovereignty.”

Vullo also argued that the National Bank Act does not provide the OCC with authority to create the new, proposed charter. “The proposal threatens to create an entirely new federal regulatory program, creating serious regulatory uncertainty that threatens to invade state sovereignty and embolden those who may seek to evade strong state consumer protection laws,” she wrote.

“Offering a new charter to non-bank companies seems at odds with the goals of financial stability, financial inclusion, consumer protection, and separation of banking and commerce that the OCC has upheld under your tenure,” they wrote. The OCC’s plan “could also allow predatory alternative financial services providers to spread more quickly given the blessing of the federal government and elimination of state-based protections for working-class Americans.”